Why healthcare may grow to 50% of GDP and still be affordable

I can't over-emphasise how important the concepts in this article in last week's Economist are:An incurable disease, and I would urge my readers to try and get to grips with it. If you want to understand how our economy is changing, and the implications for public services, the idea it describes is critical. It ranks alongside Ricardo's law of comparative advantage (gains from trade) and Keynes's multiplier (fiscal policy) as a counter-inituitive idea that explains so much.

What it describes is something usually referred to as "Baumol's cost disease", and reviews a book by the eponymous William Baumol, "The Cost Disease: Why Computers Get Cheaper and Health Care Doesn't". It stems from the observation that productivity grows in some parts of the economy faster than in others. The paradox is that the more productivity in a sector advances, the smaller its share in the the economy at large. Thus agriculture used to dominate the economies of the current developed world - but as agriculture became more productive, it needed less people and so shrank to a negligible propertion of GDP - while generating ever larger larger quantities of agricultural produce. The same effect is clearly visible in manufacturing industry - producing more goods than ever, but from a shrinking workforce. The more these areas advance, the bigger less productive sectors bulk in the economy as a whole. It is, misleadingly, referred to as a "disease" because these less productive sectors, within the service economy, then act as a drag on economic growth as a whole. It is not in fact a disease, but a symptom of success. The failure of economists to understand the difference between creating wealth and realising it (i.e. turning that wealth into something that actually benefits humankind) is one the biggest failures of the dismal science, and it is a shame that Mr Baumol perpetuates it in the title of his book.

The most important of these unproductive services are healthcare and education. Personal contact go the very heart of what these services are: to succeed these services must accept that people are individuals, and that a solution which works for one person may well not work for her superficially similar neighbour. But, while productivity grows only slowly, if at all, costs, i.e. rates of pay, must reflect the increased productivity of the economy as a whole. So costs advance faster than productivity. Sound familiar? But this only happens because we can afford it.

The eye-catching claim in the book is that on current treads healthcare will take up 60% of the US economy in 100 years, and 50% of the UK one. But this is all paid for by the fact that other parts of the economy have become more efficient - and in fact it only takes up such a large part of the economy because these parts of the economy have become more efficient. Actually this projection is a bit silly. I think the advance of conventionally measured productivity will slow, as technological change now affects quality rather than quantity. Also other sectors of the economy will reverse productivity as people value personal content more (think of the return to craft food production). But it is rather a good way to make the point.

Which means that the challenge with healthcare and education is not that growing costs are unaffordable, as various right-wing types claim, but something much more subtle. There are three issues in particular:

A lot of healthcare is indeed inefficient, both in the UK and the US, and political pressure must be brought ot bear to address this. But don't expect it to halt or reverse the share of health costs in the economy in the long run. The NHS "Nicholson challenge" in the UK may therefore be a valid policy goal, but it will not solve the long-term funding needs of the health service.

The larger the share of the economy healthcare takes up, the more difficult it will be to fund it entirely from tax. In the UK this either means that a parallel private sector will flourish and undermine the NHS (as has already happened in dentistry), or that the NHS will need to be a lot less squeamish about co-payments.

There is a temptation for the owners and workers in the highly productive parts of the economy to keep the rewards to themselves, creating inequality and undermining public the public sector. And yet we still want productivity to advance so that we can all afford a higher standard of service. Higher taxes are part of the solution, but only part. Again this points to the fact that a higher proportion of healthcare (and education) services will have to be delivered and paid for privately - allowing the remainder of the public services to pay decent wage rates.